Hedge funds follow a diverse range of strategies, such as equity long/short, macro, credit, currency and event driven. All of these styles are generally managed to outperform cash by a significant margin with relatively low levels of volatility (for example, in comparison with equities). In a year such as 2005, when bonds rose over 9 per cent, outperforming a cash return of 4.5 per cent may not appear much of a challenge. Equity returns from core markets delivered in excess of 20 per cent while Japan rose by 40 per cent and emerging markets by 50 per cent. Aggregate hedge fund returns of 9 per cent look adequate but unexciting; nevertheless, this was their strongest absolute return for some years. Another issue is that these hedge fund returns are based on averages; there will have been a very significant amount of dispersion around all of these aggregates, both by strategy and within strategies.
If we mine the hedge fund performance data, we note that the weakest results came from currency funds (up less than 3 per cent). Fixed income hedge funds returned just under 5 per cent and credit funds approximately 7 per cent. By contrast, much stronger results came from equity long/short funds with returns in the region of 12-15 per cent. This prompts the question to what extent these returns simply reflect a diluted amount of market beta. Has there been any skill involved or have the vehicles merely adopted net long positions which have essentially captured a proportion of the market rises?
There has been a significant amount of criticism of hedge funds in terms of transparency, the level of skill employed, the business risk attached to new entrants and the amounts of charges (not merely manager fees) involved in their operations. Undoubtedly, much of this criticism is valid; after all, there are a huge number of hedge funds available to investors. Survivorship is an issue, performance can be hard to interpret and fees and transaction costs all need to be covered before end investors achieve their returns.
Defending hedge funds
That said, it is important to consider what role these investments play in a portfolio; and, to be clear, they must be viewed as investments rather than an asset class. Their purpose within a structure is to deliver asset returns which provide diversification both in terms of their pattern of returns and their risk profile. On this basis, investors should be seeking stability and consistency of return. They should look for hedge funds to add performance when other assets are doing badly, not when they are doing well (as has been the case over the past three years).
Hedge funds should be skill-based. Which is perfect, because skill provides one of the best means of diversification. But that gives rise to another problem. While market beta is expected to be positive in the long term, skill is a zero-sum game (less costs).
Identifying skill
Given the lack of transparency and issues within the hedge fund universe, this suggests that for many investors a fund of hedge funds (FoHF) is likely to offer the most appropriate approach. The FoHF manager provides selection, aggregation and monitoring services. On the downside, this approach will introduce a further layer of fees that may not appear to offer value when considering aggregate results from FoHF managers. Nevertheless, this is no different than the situation for the ‘manager of managers’ approach (for core assets) or ‘funds of funds’ in areas such as private equity. The choice of FoFH manager is critical.
It was the collapse in equity markets at the start of the century which ignited the strong interest in hedge funds and the positive returns they were delivering at that time. They have been left behind somewhat in the equity rebound since 2003. But, it is vital to think about investment structure in aggregate and to consider various possible future scenarios. Over the last three years, when cash has been cheap, the prices of all assets have been lifted.
Trends do not extend forever. Investors need to consider the possibility of market setbacks. The best protection is to hold a diversified mix of investments. Many investors still retain an extreme scale of bet on a single asset class, equities; regional diversification appears to offer much less protection nowadays as market correlations have increased over recent years. The fundamental drivers of private equity are similar so that is unlikely to add much diversification either. We have seen modest steps taken into alternative assets such as commodities, while property is a more mainstream asset class still much in demand; both are likely to offer diversification from equities. But, there is a sense that all of these choices are price dependent.
By contrast, skill-based products might be expected to be price insensitive. That is the major source of diversification they can offer. Keep the faith.
John Hastings is partner and senior investment consultant at Hymans Robertson.
